U.S. economy defies expectations, so why are investors worried?

The U.S. economy grew much faster than expected in the fourth quarter, squashing fears that a recession was just around the corner.

According to the Bureau of Economic Analysis, U.S. GDP grew at an annualized rate of 3.3% in the fourth quarter, easily surpassing forecasts of 2%. Consumer spending was the main growth catalyst, expanding at a 2.8% annual rate.

The fourth quarter capped off a solid year that saw the U.S. economy expand 3.1% in 2023. As Creditnews reported, economic growth accelerated in the second half of the year as Americans splurged on experiences and services.

“It’s been a really strong year for economic growth,” James Knightley, chief international economist at ING, told The Wall Street Journal. “The consumer was meant to roll over—and they didn’t.”

Knightly was referring to widespread expectations that cash-strapped and highly indebted consumers would curb their spending heading into 2024. That clearly wasn’t the case.

Under normal circumstances, resilient consumer spending would be welcome news for investors. But this is no ordinary economy.

The Fed has been trying to put a cap on spending to cool inflation, which reached 40-year highs in 2022. Although inflation has moderated, it accelerated unexpectedly to 3.4% in December—and is still well above the Fed’s desired target of 2%.

So long as “inflation remains stubbornly elevated, the Fed will keep pushing back at the idea of imminent rate cuts,” Seema Shah, chief global strategist at Principal Asset Management, told CNBC.

For investors, interest rate expectations are the key to how the rest of 2024 will play out.

Rate cut forecasts are “premature”

The prospect that the Fed could lower interest rates as early as March has fueled a record rally in the stock market. But economists say rate-cut expectations are too premature.

“The economy [fared] noticeably better than expected in the final three months of last year, reinforcing our view that market expectations for the Federal Reserve to cut interest rates as early as March is premature,” said Ryan Sweet, chief U.S. economist at Oxford Economics.

While investors aren’t as bullish on a March rate cut as they were a few weeks ago, they’re still placing 50% odds of it happening, according to CME Group’s FedWatch Tool. The odds of a rate cut increase to around 90% in May.

Before the latest GDP figures were released, markets were pricing in as many as six rate cuts this year. According to Harvard economist Kenneth Rogoff, that’s a “pipe dream.”

Even the Fed has cautioned investors against expecting imminent rate cuts.

“While I think it’s appropriate for us to look forward and ask when would policy adjustments be necessary so we don’t put a stranglehold on the economy, it’s really premature to think that that’s around the corner,” San Francisco Fed President Mary Daly said last week.

Economists say this approach has put the Fed on track to achieving its “soft landing,” which is both good and bad news for the economy.

The boom times won’t last, economists warn

A soft landing means the Fed has successfully cooled the economy without a recession. But it also means that strong economic growth won’t last.

“It’s not to say that the U.S. economy could not go into recession. It’s just that we now believe that there is more likely than not a path to a ‘soft landing,’ where we don’t have consistent negative GDP prints,” said Sam Bullard, a senior economist at Wells Fargo.

Behind the scenes, signs of slowing economic growth have quietly emerged.

Unemployment remains low, but laid-off workers are having a harder time finding jobs. The manufacturing sector has contracted in eight of the last nine months. Major food companies have resorted to price cuts because of slowing sales.

At some point, consumers will have to cut back on spending because of their diminished savings since the pandemic, economists warn.

“That’s going to put a weight on consumption going forward,” according to Dan North, senior economist at Allianz Trade North America. “We’re looking very much at slow growth.”